We’ll cover these four general disclosures required to be made by both broker-dealers and investment advisers (plus agents and IARs by extension):
Let’s kick this section off with a definition from the Merriam-Webster dictionary:
A conflict of interest exists when a financial professional could personally benefit from something related to a client interaction. For example, an investment adviser being compensated by an issuer for recommending their security to clients. Wouldn’t you want to know if your adviser had a financial interest in recommending a specific security, product, or service to you?
Conflicts of interest are not inherently problematic or illegal. However, a conflict could be considered unethical (and potentially criminal) if undisclosed. That’s the key - disclose it, and all is well! There are seemingly endless examples of conflicts of interest, but here are some key ones to be aware of:
As you can see, nearly all the conflicts of interest listed above relate to recommendations. While broker-dealers can recommend securities, their business is primarily focused on executing transactions. The majority of trades executed by broker-dealers are unsolicited, meaning the trade was the customer’s idea without influence from a financial professional. In these scenarios, broker-dealers are not subject to a fiduciary duty and don’t run into too many conflicts of interest.
Investment advisers must always act in a fiduciary capacity with their clients. Therefore, advisers must move to remove and/or mitigate conflicts of interest as much as possible. If it continues to exist, the conflict must be disclosed. Permanent conflicts of interest are typically disclosed in the brochure. If a conflict happens to occur spontaneously, it must be disclosed during the recommendation or prior to trade execution.
When financial professionals engage investors online, certain protocols must be followed in order to ensure compliance with regulatory requirements. In 1997, NASAA released an order relating to internet communications. When the internet started becoming a larger part of our culture in the late 1990s, it was important to establish a general regulatory mindset, especially in relation to registration.
The big question - would engaging investors online be considered an action requiring registration in all states those investors were currently residing in? For example, let’s assume an IAR registered and operating in one state only is discussing securities in an online comment thread (on Facebook, Reddit, etc.). Users from all 50 states are engaging in conversation with the IAR. Does this mean the IAR must be registered in all 50 states?
It depends on the type of conversation being had. According to the 1997 NASAA order, registered persons are not considered as “transacting business” if the following requirements are met:
Additionally, the same NASAA order requires agents and IARs to:
Keep in mind these rules only apply to online communications an agent or IAR engages in while acting in a professional capacity. These rules generally do not apply when not discussing securities or when conversing in a personal manner. For example, an agent posting a comment about the stock market on a Facebook comment thread in their free time would generally not be subject to the rules posted above. As long as the comment was posted in a personal capacity and didn’t reference their professional affiliations, it would fall outside of the administrator’s jurisdiction.
To comprehend the concepts discussed in this section, you must be knowledgeable in regards to agency and principal capacities. Follow this link for a refresher on the topic.
The capacity in which a security transaction occurs must always be disclosed to investors. In most scenarios, broker-dealers disclose this on trade confirmations after a transaction is executed. Trade confirmations must be sent to investors by settlement, which is typically the first business day after a trade occurs (depending on the security; the details are not important for the Series 65).
While most disclosures of capacity occur after a trade has been executed, some instances require pre-disclosure. In particular, a pre-disclosure must be made if an investment adviser’s recommendation will result in a principal transaction. For example, an adviser recommends ABC Company common stock, which will be sold out of the adviser’s inventory if the client agrees to the trade. This is another example of a conflict of interest that must be disclosed during the recommendation.
Agency cross transactions also require some pre-disclosures to be made. This type of transaction occurs when an investment adviser “crosses” two of their own clients on the same trade. For example, let’s assume an adviser has two clients - Leon and Ebony. On a quick phone call with their assigned IAR, Leon expresses interest in buying Tesla stock. Later that day, the IAR analyzes Ebony’s account and identifies her current position in Tesla stock as being unsuitable. The IAR recommends Ebony liquidate the position, and she agrees. The IAR gets back in touch with Leon, connects the two clients on the trade, and earns an advisory fee from Ebony.
The previous example would not be considered unethical if the following conditions were met (according to NASAA rules):
In the example above, the transaction was only recommended to Ebony. This complies with the last condition listed above. Beyond this requirement, written disclosures and approvals must be retained prior to executing an agency cross transaction. And don’t forget about the annual disclosures that must be made to all clients. As long as the proper disclosures and approval existed in the Leon and Ebony example, it would’ve been a compliant agency cross transaction.
Financial firms and their representatives may provide access to third-party research reports as an ongoing service. Many of these reports offer investment insights on specific securities from the perspective of professional analysts. With the added data and information, clients are better equipped to understand the financial markets and succeed as an investor.
There’s one big requirement cited in NASAA rules - disclose the source! It’s important the registered person does not insinuate it was their own research in order to impress their client.
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